China Regulator Tries Again To Rein In Banks’ Shadow Assets

A woman leaves a branch of the Shanghai Pudong Development Bank in Beijing July 6, 2011.
Photo:
Reuters

In the pursuit of order in its financial markets, China's banking regulator has tended to be one step behind in keeping up with a decade-long dalliance between commercial banks and the country's non-bank lenders, called the shadow banking sector. Its latest directive suggests the government might finally be trying to get ahead.

Bankers and analysts say the China Banking Regulatory Commission issued a notice to commercial lenders last week, taking aim at a shadow-banking product that has allowed banks to hide loans, including bad ones, from their books.

The watchdog has tried cracking down on similar arrangements in the past. But this time, it appears to have taken a more nuanced approach in order to more effectively get at banks that originate the loans underlying these products.

In its crosshairs is a relatively obscure instrument called credit beneficiary rights, a product that is derived from shadow-banking deals and can then be sold between banks.

The CBRC’s new directive in part takes aim at this practice by calling for banks to stop investing in credit beneficiary rights using funds raised from their own wealth management products.

In China, shadow banks' dexterity and relentlessness at product innovation have regularly pushed them right to the edge of what their regulators can tolerate.

The CBRC directive, known as Notice No. 82, is the latest in a cat-and-mouse game that banks have played with regulators for years. Beneficiary rights are themselves an innovation to circumvent a CBRC clampdown in 2013 and 2014 on banks directly buying trust products in a similar arrangement to disguise loans, and then developing a lively interbank market for these rights transfers. There have been regulatory interventions on variations of the practice every year since 2009.

The commission hasn't publicly released the directive and didn't respond to a request for comment. Analysts say the regulator is likely now huddled with banks to gauge how hard they will push back and how thoroughly the regulator can implement the requirements.

Beneficiary rights confer on the buyer the right to a stream of income without ceding actual ownership of the underlying asset. That asset is often a corporate loan, which may or may not have already soured, though it could also be anything that generates an income stream, such as a trust, a wealth management product or a margin financing deal.

When one bank sells credit beneficiary rights to another, the transaction allows the first bank to use the accounting change to turn the underlying loan on its books into an "investment receivable." The rules require banks to set aside about 25% of the receivable's value in capital provisions, compared with 100% had it been a loan.

The deals get more complex as layers are added to further disguise the loan. Banks will have third-party shadow financiers extend the actual loan to the company, in exchange for the bank's purchase of beneficiary rights to the loan's income stream. These deals are often laced with side arrangements, called "drawer agreements" because of their secretive nature, in which banks essentially guarantee the underlying loans.

In some cases, analysts say, banks are raising funds directly from retail investors by touting the bank's own wealth management products, then using the funds to purchase beneficiary rights to a loan that the bank had itself generated – creating a range of problems with accounting and disclosure.

Analysts say regulators now appear to be testing a slightly different approach to resolving the problem of banks attempting to disguise loans. This time, Beijing is singling out a relatively small subset of receivables; credit beneficiary rights are estimated at about 23.5 billion yuan ($3.6 billion), less than 1% of the total universe of receivables of about 13 trillion yuan ($2 trillion), said Wei Hou, senior analyst with Bernstein Research.

The directive also urges banks to make adequate provisions for the underlying asset, even if they have ostensibly moved it off their books, analysts say.

"In my view, Notice 82 is an experiment to start with," Mr. Hou said. "The attitude is different this time, focusing more on the ownership of the underlying instruments."

It isn't clear whether the directive may eventually be expanded to the wider universe of receivables.

Receivables last year were highest at Industrial Bank Co., Shanghai Pudong Development Bank Co. and China Citic Bank Corp. The banks didn't respond to queries. The nation's biggest banks have mostly held back more from arranging such receivables, analysts say.

The new measures could bring more transparency but also "can have unintended consequences sometimes, where banks try to shift asset classes to bypass prudential measures,” said Fitch Ratings analysts Grace Wu and Katie Chen.

Ultimately, how large of a problem is all this?

At the end of last year, investment receivables at listed banks totaled around 15% of yuan loans, valued at 59 trillion yuan ($9.1 trillion). For the larger universe that includes unlisted banks, the ratio drops slightly lower to 13%, by analyst estimates.

By comparison, in mid-2008, months before the onset of the global financial crisis, off-balance-sheet assets at U.S.-based Citigroup stood at around half of total assets. On the back of the envelope, the figure in China is still not as bad as where things were for some global banks back then.